Failure to get a handle on cash flow is a recipe for disaster. So, have you started managing accounts receivable for increased cash flow?
Business success relies on good inflows and outflows of cash. The perfect inflow is revenue paid with cash, but normal business operations allow customers to pay on credit. When this happens, it is recorded under accounts receivable on the balance sheet.
But too much money tied up in accounts receivable means less cash to pay invoices. Even though you have earned money, and you know it’s coming, that does not mean you have positive cash flow. Maintaining a proper balance of accounts receivables and cash is critical in healthy financial modeling.
The good news is that managing accounts receivable for increased cash flow are a matter of looking at how you handle invoices and customers that fail to pay on time.
Effect Of Accounts Receivable On Cash Flow and Financial Modeling
Accounts receivable is money a client or customer owes you for goods or services already provided. The invoice is sent to the customer with a 15-,30-, 60- or 90-day term in which the company needs to pay.
If they do not pay the debt during this required time, the payment is past due and can incur a late fee. If the customer still fails to pay, in-house or outside collections must be initiated.
Ensuring customers pay within an agreed-upon time frame is critical to proper cash flow. You can allow your customers to have longer payment terms if you have good cash flow. But poor accounts receivable management can result in a negative cash flow, affecting your ability to turn a profit or get a loan.
Recording Your Account Receivable
Accounts receivables are recorded on the balance sheet under current assets and are an important factor in a company’s working capital. There is less money for operations, investments, inventory, or other expenses if a customer fails to pay their invoices.
When recording your accounts receivable balance, the company’s inventory decreases by the same amount as the accounts receivable increase. When the customer pays the invoice, cash increases, and accounts receivable decrease.
If a customer pays half and promises to pay the other half in 30 days, the half they paid is cash in revenue; the other half is recorded as accounts receivable until the balance is paid.
Monitor accounts receivable over several reporting periods to determine accurate cash-to-receivable ratios.
An increase in accounts receivable indicates that sales are paid more with credit than cash. Upward changes in accounts receivable are deducted from net earnings on the cash flow statement.
A decrease in accounts receivable means that your customers have paid their invoices, or your collections efforts have been successful. Downward changes in accounts receivable are added to net earnings on the cash flow statement.
Days Sales Outstanding (DSO)
Days Sales Outstanding (DSO) is a metric used to predict accounts receivable. DSO is the average number of days it takes for a customer to pay their invoice.
The formula used to calculate DSO is accounts receivable divided by total credit sales multiplied by the number of days you want to track.
DSO can determine the number of sales made during a time period, how quickly your customers are paying, and the average time it takes to collect your invoice. It can also tell you if you are giving credit to customers who are not creditworthy.
For most businesses, under 45 days is a good DSO number, but this depends on how your cash flow management works. If your DSO is 15 and you struggle to pay your bills, you may need to change your policies.
Over time, if your DSO is increasing, you need to ramp up your collection efforts or change your payment terms.
DSO is a valuable number to know, and investors can use it to interpret the efficiency of your operations.
How Does Accounts Receivable Impact Financial Modeling?
Financial modeling is used to predict the future.
Accounts receivable is a good predictor of how much cash the company will see in the future when their customers pay their invoices.
Calculating DSO is one model used by companies to understand how long it typically takes a customer to pay outstanding invoices.
If you check your cash flow statements and find your accounts receivable are too high, a company needs to address payment delays. The company may also be lax in collections efforts. It may become harder to pay bills with less cash on hand.
On the other hand, if accounts receivable is low, it may indicate that the company has too strict payment terms and there may not be enough leeway offered to customers. The goal is to strike a good balance that works for you.
Accounts receivables are seen as positive on financial statements as it indicates an amount that will turn into cash in a specific time frame. However, if the money is not collected from the customer, it could turn into a write-off on the balance sheet.
How to Optimize Your Accounts Receivable to Improve Cash Flow
If your accounts receivable are rising, or you struggle with billing and collecting payments, there are several things you can do in-house to improve cash inflows.
- Ensure you send accurate invoices as soon as the work is complete. Any delay in invoicing is also a delay in getting money in the door. Electronic invoices are quicker than through the mail and often easier to keep track of.
- Ensure your credit terms are working for you. If you are just starting out or struggling to keep up with your bills, you need cash on hand quickly. Setting your payment terms to 15 or 30 days or even payment due on receipt is perfectly acceptable. You can reevaluate your policies as you grow and as customers earn your trust with timely payments.
- Follow up with customers as soon as a payment is missed and encourage others to pay invoices before other goods or services are sold to them. An application specifically designed to track accounts receivable ensures that you keep track of invoices and payments.
- Don’t hesitate to use a collections agency when customers are not cooperating. After exhausting your efforts to negotiate nicely, your time is better spent focused on other areas of your business than chasing them around. Money obtained by the collection
Pushing Customers to Pay On Time
Once you’ve cleaned up your internal invoicing and collections processes, you can look at ways to get your customer payments back on track. It’s better to have a plan of action rather than hope your customers will pay on time.
Any system will require a sound tracking system to follow up when payments are due rather than waiting until the numbers look ominous on your balance sheet.
Incentivize Early Payments and Penalize Late Payers
A simple step employed by many companies to get them to pay quicker is a discount. If the customer pays on or before their due date, they get a percentage off their total bill.
While the cash received is less than the invoice, cash hits your account much earlier. This cash inflow can be used in investments to make back the discount.
You can implement a late-fee policy if a customer does not pay their invoices on time. Knowing that they will have to pay an additional charge if their payment is 15-30 days past due is often enough incentive to pay on time.
Investigate Prospective Customers Thoroughly
The best defense is a good offense. Before giving new customers extended lines of credit, research the client’s history. Check with the buyer’s credit report or ask for references.
Remember that whenever you offer a customer credit, you are a lender and should take proper precautions. Until they prove they are creditworthy, ask for a deposit or payment terms shorter than other clients. Trust your instincts.
Report Customers to Credit Bureaus
Don’t hesitate to report customers to credit bureaus like Dun & Bradstreet, Experian, or Equifax if they are chronically late or refuse to pay altogether. Make sure this is part of your customer policy and is clearly communicated to the customer upfront before actually reporting them. Sometimes this is the motivation for them to pay.
Revoke Credit Terms
If your accounts receivable is becoming a problem, change your payment policy. With proper notice, you can change from 60 or 90-day payment terms to 30. Once your DSO is back in order, you can consider extending these terms to your best clients.
Covering the Cash Flow Gap With Capital
If you do not want to mess with your payment terms and following the above suggestions does not solve your cash flow problem related to accounts receivable, there are other things you can do to boost capital.
Use a Business Credit Card
Companies often have trouble coordinating cash inflows and outflows. The last thing a company wants to do is damage its credit by paying invoices late.
A business credit card can add a cushion that covers the gap. Find a business credit card that allows you to pay back the money within 30 days interest-free.
Apply for a card before you need it, and only use it when you need it and when you know you can pay it back quickly. When done right, credit cards can cover the gap between invoices and payments.
Get a Line Of Credit
A line of credit can also bridge the gap caused by increased accounts receivable.
Apply for a line of credit before you need it so it’s there when you need it. You won’t get charged interest unless you dip into the money; you will not need to pay any interest. If you do, interest charges start immediately, but they are generally lower than credit cards or other loans.
Factor or Finance Accounts Receivable Invoices
Some companies buy outstanding accounts receivables, allowing you to make some quick cash. These “factors” often pay you 70-90% of the value of the invoice upfront.
When they collect the money from the customer, they give you the rest of the percentage minus a “factoring fee” of 1-5%.
Generally, these factors work with higher revenue companies, so this might not work f you are a smaller-sized company, but it’s worth looking into.
Credit insurance reimburses companies for invoices they will never collect on. This ensures that if the money is never collected, you will still have the opportunity to receive the total amount of capital.
Require a Deposit
Depending on your line of business, and especially in a service business where you need to purchase supplies upfront specific to a customer, you may request a deposit from a customer.
A deposit is not unreasonable even in service businesses where you can estimate a lot of time spent on a project. Paying in installments is another option—request payment at specific steps in the process. These could be based on deliverables.
The important thing is to present the same terms for all customers.
Renegotiate With Your Suppliers
In the same way, you set or negotiate payment terms with your customers, you can negotiate terms with your suppliers. They may be receptive if you’ve had a long-term relationship and always met their last terms. It helps if you explain the reason for your request.
The Final Word
To add some focus, accounts receivable is a line item on your balance sheet. It affects cash flow which in turn affects your ability to pay invoices. If you can’t pay your bills, you invite an avalanche of issues.
Many businesses feel that customer payment issues are inevitable, but we’ve outlined many steps you can take to improve this one area.
Pay attention to your financial statements and take action as soon as you see accounts receivable numbers rising.
Revisit your invoicing and payment policies and adjust them to meet your needs. Soon your cash will flow easily in and out of your company.
For more tips on how to keep more of your money, check out our library of articles.
